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07/19/2009

The Drop in University Endowments and What to Do about It--Posner

College and university endowments have taken a big hit from the drop in the stock market and other asset markets. A drop of 20 to 30 percent is common, and there is suspicion that endowments that contain a significant proportion of assets that are not traded on organized markets, such as real estate, have dropped even more, but without "marking to market" their nonfinancial assets.
The effect of a drop in the market value of endowment on a college's or university's finances depends on a variety of factors. I will give a hypothetical example that may help in understanding the issue. Suppose X College has an endowment that before the crash had a market value of $1 billion. In normal times X cashes 5 percent of the endowment each year to contribute to X's budget, 5 percent being a widely used estimate of the average real return of a typical university investment portfolio. Suppose X's total annual budget is $200 million, with a quarter contributed by the income on the endowment (5 percent of $1 billion = $50 million), a quarter by alumni gifts (apart from gifts intended to become part of the endowment), and a half by tuition. In the economic downturn, I'm assuming, the endowment has fallen by 30 percent, to $700 million; tuition net of financial aid has dropped by 5 percent (because of inability of parents to pay tuition, as a result of declines in their income and wealth); and alumni gifts have (for the same reason) fallen by 10 percent. Then College X's income will have declined by 12.5 percent, from $200 million to $175 million, assuming the college continues to treat 5 percent of the (shrunken) endowment as income.
What should X do (other than expelling its suddenly impecunious students and replacing them with affluent ones of less academic promise)? The typical response has been to cut spending by the amount of the drop in income: in my example, that would require X to reduce its spending by 12.5 percent, which it can do in various ways, the usual ones being laying off staff, freezing hiring of faculty and staff, delaying construction, deferring maintenance, reducing staff salaries, and curtailing extracurricular activities.
At first glance, this seems a puzzling response. Why all this dislocation, instead of either spending capital (that is, taking more than 5 percent out of the endowment) or borrowing? Take borrowing first. Unless a dollar is worth less to College X this year than it will be next year (or whenever its income returns to its normal level), why should it spend less when it can spend the same, with modest effect on future spending, by borrowing (in my example, $25 million)? Lending and borrowing are methods by which the marginal utility of income can be equalized across time when total income varies from year to year. Harvard is borrowing more than $2.5 billion, but it is still cutting its budget by 10 percent.
Similarly, although "spending capital" is a familiar example of improvidence, it can make perfectly good sense. In my example, College X is short only $25 million, and if it takes that out of the endowment, the endowment will fall only from $700 million to $675 million. A problem may be that donors of endowment money may have placed limitations on spending, fearing that a gift that they intended to be perpetual would be eaten up if X dipped into the principal of the gift. But not all endowment money is restricted in this way and trustees of trust funds usually have authority to dip into principal in the event of an emergency. However, X may fear that if it does that it will discourage future contributions to the endowment.
Given that last concern, borrowing seems the superior alternative to spending capital, and yet most colleges and universities seem reluctant to use borrowing to fill the entire gap between income and expenditure; otherwise they wouldn't be cutting spending. Granted, credit remains tight, but the elite universities, at least, are fiscally sound and have alumni in positions of influence in the credit industry.
Maybe the reason the colleges and universities are not borrowing more is that they do not expect their income to recover in the foreseeable future. Nonelite colleges depend heavily on state aid, which is likely to be meager for a number of years--state budgets are in terrible shape. And they draw students from the segment of the population that has been hardest hit by the economic downturn. Elite colleges and universities depend heavily on federal research grants, which may diminish as the government tries desperately to control the rapidly mounting national debt, and on donations by wealthy alumni. Many of those alumni have suffered a permanent reduction in their wealth, and many others are facing the increasingly likely prospect of having to pay higher income taxes, which will make it more difficult for them to pay their kids' tuition. Elite universities may have to limit tuition if they want to attract the best students.
A protracted economic crisis has different effects on different industries, because different industries have different vulnerabilities. The current crisis is speeding newspapers, and print media more broadly, to an early grave, and may yet destroy all three Detroit automobile manufacturers. It will not do in the colleges and universities, but it may have a lingering adverse effect on them that may explain and justify immediate measures to reduce expenditures.

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and may yet destroy all three Detroit automobile manufacturers

Looks to me like Ford is going to make it.

Better than borrowing, universities should consider generating revenue by giving up more of their patent rights to commercial partners interested in university research. See the editorial by Stephen Quake in the NYT from a few months back:

The 5% budget contribution by endowments has been widely recognized as the "right" number to ensure that the endowment can continue in perpetuity. Borrowing is just a different way of expressing an increase in the amount withdrawn from the endowment and would be irresponsible.

The question for universities is how they got themselves in this situation in the first place.
Take Yale, by way of example. In 1998 the endowment was $6.6 billion and the operating contribution $218 million. In 2008, the endowment was $22 billion with $850 million in operating contribution!

If the endowment was contributing 25% of the budget in 1998, it is now able to contribute roughly 100%. Absent increased spending, there's no crisis.

Instead, all of the universities are forced to cut back, since they've been spending like drunken sailors. I'm not sure this is much of a problem, simply a return to normalcy that should have been anticipated.

All of these "dislocations" occuring across the Board are the result of the "Panic Mode" into which Institutions fall when finacial failure or the spector of it begins to occur (who says Econ. is rational?). From a Microeconomic stand point it may appear rational, but from the Macroeconomic stand point, it is irrational and a disaster in the making. Much like the Domino Theory at work, driving the Economy into an ever steepening downward spiral.

For an Economic recovery to occur, the stimulation by way of Capital Investment and spending must occur. Even if it is based on the requirement of borrowing in order to do it. And this must take place across the Board by all Institutions. We need to put approximately 7,000,000 + people back to work, so that the consumer based economy can pickup and move forward. Which will solve many of the problems we confront today. As for those systemic problems within the Financial and Banking Industry that created this mess in the first place, we've rediscovered the reasons why this Indsutry was regulated in the first place.

I think you make some incorrect assumptions in this post. Tuition is not on the decline. Quite contrarily, during the economic collapse, education has been the one sector that is still expanding as the opportunity cost of attending college drops.

You and Becker are probably right that colleges have cut spending "too much" instead of borrowing into a deficit to pay their bills. With that said, any financing decision today can have long-term consequences tomorrow, which can have profoundly negative results.

My intuition suggests that the cuts in spending are a good thing until income from the endowments returns. It is unfortunate that a reduction in the performance of the stock market results in reduced investment, but this is inevitable during a contraction in the economy. Consumption is not the only thing that contracts during a "depression" (as you call it), investment and savings must suffer, also.

I do agree that *some* debt may be good because no organization can expect to forecast its revenue with 100% certainty. But spending into a deficit in bad times must be constrained by realistic projections of income, lest higher education begin to look like our government with its spending.

Just like all of the other American do: work one day of a week without pay. Work sharing for a change. I thought the MBAs would implemented the solution easily at school. A nice real world training before graduation.

Why not furlough employees like the public sector has been doing? This way everyone keeps their jobs, overall cost to the school decrease and it will be business as usual when the economy and endowment pick back up.

Not to worry. When Obama gets through, everyone will be guaranteed a college education so there won't be any need for endowments. Isn'th that what he has said. AND all of the colleges will have to have the same buildings and functions, sort of like a soviet apartment block.

In 1996 Norway established a special fund in order to manage revenues from the petroleum sector (Norway is the world‚Äôs 5th biggest exporter of oil ‚Äì with only 4.8 million inhabitants). Revenues from the petroleum sector are invested in various foreign assets (shares, sovereign debt, corporate debt etc). The fund has increased from 113 billion NOK (approx 16 billion USD) in 1996 to 2275 billion NOK (approx 325 billion USD) at the end of 2008. The central bank, Norges Bank, manages the fund on behalf of the Finance Ministry.
In 2001 Norway decided to apply a special rule for use of funds in the domestic economy. According to this rule a certain part of the expected real annual growth of the fund (estimated at 4 % per year) can be included as revenue in the annual budget of the Finance Ministry. The extract from the fund can be larger or smaller than 4 % in case of unexpected negative or positive events, such as a sharp reduction/increase in asset prices, oil price etc. Based on this the Norwegian government seeks to level out the proceeds from the fund. In this way the annual budget is sheltered from short-time variations in exogene variables.

This analysis omits a primary source of funding for many institutions, research grants. Certainly if College X is one of the elite, it attained that status by having elite research, but even 2nd tier schools compete for money. Unfortunately research money started getting limited even before the current economic crisis.

Presumably, the authors understand that bond ratings for colleges and universities are, in part, determined by preset ratios of debt to assets. If colleges and universities utilize loans to cover their losses temporarily, they run the risk of negatively impacting their bond ratings, and such negative impact would lead to further difficulty paying off debt, especially if, as Posner suggests, there is a worry about increasing revenue in the foreseeable future. My sense is that this analysis would work for private research institutions and state schools alike, because the private institutions' prestige will guarantee demand from prospective students (thus ensuring, at worst, tuition income) and state-funded institutions will fill with students from smaller, less prestigious private institutions who can no longer afford the high cost of tuition.

Now that said, I don't see how this analysis can apply to smaller, less prestigious private institutions--in particular, small liberal arts colleges. Their endowments never were, are are surely not now, capable of coping with significant declines in enrollment. And considering the hit that endowments have taken in tandem with the glut of debt accumulation in campus and program expansions in the last decade, it's difficult to see how smaller schools can afford to take on the kind of debt that will be necessary to get them through these times without negatively impacting their bond ratings in the way I've already described.

So that said, Judge Posner, any suggestions for schools such as these, or have I overlooked some feature of your argument that would make it applicable to those institutions?

I think the problem is that not only are large parts of endowments probably tied up with specific restrictions, but in the case of universities like Harvard or Yale, both of whom had aggressive investment strategies, a lot of their assets were tied up in illiquid operations. I'm pretty sure Harvard invested in lumber operations at one point, and they cannot quickly liquidate their endowment despite its size. Thus it's possible that despite the large sizes, a lot of their endowments are just not accessible, even if they wanted to dip into it.

I wonder why we have come to believe that colleges and universities have to have enormous budgets to fund activities other than educating students who pay to be educated. All we really need for EDUCATION is funding for some functional but aesthetically attractive buildings resting in a tasteful campus, salaries for talented teachers, salaries for necessary staff, and a library. What we do not need is all the research, elaborate athletic programs, and facilities to house activities unrelated to education.

If someone wants to set up a research foundation, fine. If others want to set up a health club, fine. But students are being cheated at most so-called top tier schools (and on down the line except at a few liberal arts schools) as college administrators hire professional researchers who demonstrate little interest or ability in teaching.

I find it quite ironic that, during better times, colleges said that they couldn't spend more of their endowments because they needed to save that money for a rainy day. Now they say they can't spend it because it's raining.